How to your Real estate investment LLC or entity and what entity to choose
Chapter 3: Step 2.
Open two LLC’s. Step 2 in the quick start guide
Time: 2 Hours, Day 2
Now that you know what state you want to do business in, it’s time to open up your legal entities. Different entities have different benefits. You need to talk to your local real estate attorney to understand them, but below is a short and generalized description of the different entities. For me, I always prefer LLC’s, but in some states like in Pennsylvania I use LP’s (Limited Partnerships) managed by my LLC to hold my properties. That Management LLC does all the business decisions and is the liable partner in the arrangement. More on this in a moment.
!!!: This is a long hard topic. It is a combination of 10+ high level college courses, many professional books and courses, and years of experience, confusion and discussions. I’m trying to distill the most important factors here to give you an understanding of the issue so that you can discuss it and build a mindset around it for success. This topic is the secret to almost all successful investors, and I cannot understate the importance of it, but give yourself time to learn and understand it. It’s part of a growing process, when you review it later, different things will make sense to you. I hope you find this interesting and easy to digest.
Why bother forming entities? There are a few primary reasons to having an entity.
In general, you will see that you get the same asset protection from each kind of entity (LLC, LP, LLP, PLLC, Corporation…), but what will cause you to chose one over another are the federal and state tax consequences of those.
I’m going to try to avoid making this chapter overly complex and not put you to sleep. Keep in mind that as long as you get asset protection (by forming any LLC or LP) you can later go and fix things. So do not let all this stop you. If for some reason, you cannot get legal and accounting advice that makes sense you to, just go open an LLC, make lots of money, pay your taxes and a few years down the line, revisit the issue and figure out how to better run your business. Please do not allow yourself to stop here because you don’t know the best way to save a few pennies. Protect yourself by getting at least an LLC and by running it well.
Note: Can’t decide on an entity?
If you cannot figure out what to do, don’t get stuck. Go with an LLC(s).
Note: Flippers, a word of advice – Create an Entity:
If you are going to be flipping properties, then you only need one entity (S-corporation often, but LLC at the minimum) and that one can do all the business for it. There are advanced considerations, but that can be addressed after you have been in business for 1.5 years and flipping properties. Do not flip properties in your own name. You can be liable for work done on a property for 7 to 14 years, risk dealer status and why carry that kind of personal liability.
What is an entity? It’s a fake (fictitious) “persons” created and governed by state law (recognised by the IRS when you get your EIN). Basically it’s an agreement between you and the state. If you follow the terms of the agreement/contract then the state will limit the liability incurred by the business to the assets of that business. This is to prevent creditors from taking (seizing) assets belonging to the business’s owners. The state offers a few different contracts (types of entities, LLC, LP, corporations, trusts…) that have different benefits and weaknesses.
Limited liability does not mean that you have no liability. There are times when a judge will say that the entity is not really an entity and is rather an alter ego (a fake you) and let creditors seize your assets or assets of other companies that you have. This is common when you don’t have enough assets in a company or your are mixing personal expenses with business expenses or just not operating like a real company. Remember to keep good records because the IRS may want to milk you also. Things to avoid:
Having many entities with too few assets. For example. If you put one property in each LLC trying to make it so that if one company gets sued, you only lose one asset. Judges tend to hate this because it’s obvious that you are trying to “hide” behind the entity. It’s obvious and does not make business sense in the long run also (it can be expensive to maintain a lot of entities in accounting, time, insurance…)
Having no equity in your entity. This one is a little bit more blurred, but if you are obviously using leverage to make sure there is no money to be lost in the entity then you run the risk of them going after your personal assets. There are asset protection schemes that use a llc to create a fake mortgage. There are times when you can use this strategy properly, but you will be treating them as separate businesses, there will be transfer of money or equitable consideration, and you will be on some sort of payment arrangement and the lending entity will be filing taxes, and hopefully lending to other customers.
Paying for personal things out of your business. For example, buying a video game system with a business check/credit card and declaring it as an office expense. If you have to do this, call it a owner draw. Optionally ask your CPA about declaring it as a gift.
The moral of the lesson is that it is wise to mitigate risks by using entities, but trying to hid behind entities can backfire. Hots get fat, pigs get slaughtered. I’m looking to help you get as much as you can and keep it!
Why would the state give liability protection in the first place? It might seem unfair that if you have a company that did something that resulted in an injury that they could not sue you for everything they deserve, but that fact of the nature is that if the government didn’t give investors the chance to protect themselves and avoid risk, there would be very few people doing business and it would be too expensive for the customer to afford. Think about it, if Dr Joe had lots of money that he wanted to invest, but would risk losing his home, his car, and his wife’s jewelry, then he will not buy those investments. It will just be the guy that has nothing to risk and nothing to lose (Piper cleaner Pete) that will do business and thus, probably only will have ghettos, and once Pipe cleaner Pete has made some money, hes going to find a way to get rid of that liability. We as a nation need to have a way to protect investors, one of the first and most basic ways is with entity liability protection. Obviously other big ones are insurances, inspections, delegation of responsibility and warranties just to name a few.
“Charging order” protection (how LLC’s/LP’s protect you from yourself) – Phil Loves it!
So what happens if while walking into the mall, someone runs you over and then hurts themselves by running into a wall, and then subsequently sues you and a jury awards them 5 million because they find out you are rich and they are not. They discover that you have a house with 15k in equity (not enough to make you sell it considering it’s your homestead and realtor fees would eat that up), you have a car with 5k of equity (still a long cry from the millions the jury awarded) and an LLC worth millions. There is good news (and not just that you have successfully built a great company)! So the poor person that ran you over will be able to seize your assets, stocks, car and so on, but they cannot take your LLC (or LP). For that they need to get a “Charging Order” from the court. This means that what ever the company pays out to you, the poor car driver would get. But there are a few reasons that they creditor might not choose to obtain a charging order:
If your LLC was properly structured and managed, and has a reasonable manager, the manager could refuse to make any distributions of cash on your shares. Meaning that the creditor would get no money.
Further adding injury to insult for our poor car driver victom, they would get a bill from their friends at the IRS because the IRS treats the person holding the “Charging Order” as the woner of those shares and even if they were not paid out a distribution, they are still considered revenue.
In the end, the poor car driver would not get their money from the LLC, end up paying taxes on that money that they did not get, and thus not be able to pay their over priced attorney’s what they deserved for bring “justice” to the world.
In fact, when the attorney’s reviewed the assets and LLC they would probably decide not to sue in the first place because they weren’t very likely to get paid and most attorney’s don’t like making less than minimum wage.
Charging order protection does not hold in every state, and there are states (like Florida and California) that under some circumstances go around the need for a charging order. It’s not a perfect solution, but consider it a strong tool to deter creditors and help settle (negotiate) disputes. [More details on how I implement this in the newsletter, if you haven’t signed up, go right away and sign up so that you can get those free bonuses to help save you thousands now and many more in the future.]
Moral of the lesson, own nothing and control everything! (Think like the rich, there is a reason they are still rich).
Limited Liability Company – LLC
LLC’s are a legal entity that is designed to limit the risk that the owners of the company take. The members/owners of the LLC only risk what they have contributed to the company (along with any personal guaranties they have made, bank loans or private money loans that require a personal guaranty). As long as you keep your LLC in good standing, you cannot get personally sued and lose your own assets because of something that the company did. [Warning: some states do not respect this liability protection. Florida is an example of a state that does not grant a personal liability shield in some cases. Guess what one of the states that I might avoid or even use a Nevada corporation in conjunction with trusts?] LLC’s are easy to setup and easy to maintain. They do not REQUIRE annual meetings and many of the complex management tasks of a C-Corp or S-Corp. But even though some of those things are not required, IT IS a really good idea to observe them anyways. The more authentic your business looks, the more protected you will be if you end up in court. In general, I like holding properties in LLC’s. Especially ones that i’m going to hold for rental or for more than a year. Do not put flip properties and rental properties into the same entity unless you really know what you are doing!
Note: IRS tax elective:
Federally you can chose to have your LLC taxed as a c-corp, s-corp, or pass through election. Most of the time you will you will use a pass through but that can be changed. You have 90 days from the day you get your EIN to change it if you feel you have made a mistake. But in general, your asset holding companies should be pass through and the management company is more open to tax strategies. If you want to keep things simple, then use a pass through election for your management entity, but if you want to be considered an employee and get earned income from your company (a great option once you are large enough) then consider the c-corporation election. These considerations need to be discussed with your CPA because I expect a lot of things to change in the IRS as the government’s debt becomes more and more toxic.
Limited Partnership – LP
LP’s, this is a legal entity that is designed to have a managing partner that is liable and a limited number of partners that contribute to the company but do not manage the company and are therefore not liable and only risk their investment. I recommend that if you do use an LP, to have the managing member to be a LLC. That way you get the benefits of an LP along with the benefits of an LLC. In many states there is no difference to speak of, but in others you get better tax benefits. LPs are often associated with estate planning which is a topic far beyond this post and many attorneys that think they are good at it should not be so confident.
Corporations come in two flavors, S-Corp and C-Corp. S-Corps (a specific filing status with the IRS) does not pay any federal income taxes, but comes with a list of restrictions. If you are a high income earner then this strategy can help shelter parts of your business income.
The hardest part about getting advice is finding good qualified advice. Bad advice can and will often kill a good company and it can be expensive and time consuming at best. Bad advice can cost you years, partnerships, and really get in the way of your soldiers working (your soldiers are your hard earned dollars, every one of them needs to be working really hard for you).
Don’t take advice from me on entity formation. I know, before I said if you cannot make up your mind, just do this or that. The thing is that I’m probably not you, and even if I’m doing business in the same state, I have different needs and motivators. Also, I’m not in the law, trails and dealing with the IRS regularly and seeing how people are suffering from bad choices in such an intimate way as a good CPA and real estate Attorney. I’ve seen really good CPA’s give terrible legal advice, and great attorneys give really good legal advice and terrible tax advice. It gets complicated. Get all the information, and if you are confused, try to get your favorite CPA and your favorite attorney on 3 way phone call, or even better, dinner! Record that conversation if everyone is ok with it so that you can review it later. If you find yourself taking more than 3 business days to make up your mind, you are stalling and wasting time (if that is you, Phil says “STOP DOING THAT and lets get to work and MAKE SOME MONEY!!!”).
Warning/Bonus: Don’t register your entity and EIN before you read the first Newsletter. If you registered for the newsletter, in the first letter there is a special discussion on tactics with your entities that will help you later when you are raising funds, don’t miss that as it will help you raise lots and lots of money (I can only fit in so much detail on this blog without it becoming a book).
Go to the Secretary of State in the state that you want to buy properties in. This this yourself to save a ton of money!
Buy And Hold:
First LLC is your Operating LLC.
Call it something other than your personal name and do not include any real estate terms (or terms that imply a professional certification such as Accountant, CPA, ect).
Something like “<Local city> Super management LLC”.
Do not waste too much time coming up with a name.
Second LLC is the LLC (or other entity) that you use to hold your properties in.
Call it anything you want. Ie, “Things that rhyme with Dime”.
When you buy your first few properties, put them into this LLC.
If you have different sets of partners invested in different properties, give them their own LLC.
Make the First LLC (your operating LLC) a 1% owner.
Flipping is done out of one LLC. They are generally operated for 5 to 8 years after which it’s time to open a new LLC and to close business from the old LLC. This is done because in many states you have 11 years of liability from (some) work you’ve done on properties. Make sure you follow the guidelines for maintaining your LLC in good standing.
Note that for flipping, it might be better for you to create a c-corp (or register your LLC as a c-corp) for taxation purposes.